Investing

How to Play the Banks After Stress Tests

The stress tests are finished and so, it appears, is the rally in financial stocks. Financial shares, as measured by the Financial Select Sector Index, have dropped 13% since May 8, when the stress tests results were announced.

The decline shouldn't have caught investors by surprise. Banks—both those in need of capital and those deemed sound—are scrambling for billions of dollars in cash by selling stock and converting preferred shares into common, diluting shareholders' equity in the process. Banks are also taking on new bonds and selling assets, moves that could impact their future earnings and ability to pay debt.

What does all this mean for investors? On the assumption that the banks aren't going bust, intrepid investors can find value in securities issued by financial firms in everything from bonds to more esoteric securities.

For bonds, buy senior debt

For investors seeking less volatility, bonds could be an option. If the stress tests have done nothing else, they've confirmed the government's commitment to keeping the big banks afloat, although it might be presumptuous to assume that such support will last indefinitely. For this reason, Jason Graybill, a senior managing director at Carret Asset Management, recommends sticking with shorter-maturity bonds, say in the three- to four-year range. Yields can range from around 4% for Goldman Sachs (GS) debt to over 8% for a Citigroup (C) bond maturing in three years.

"From a risk-reward perspective, the bonds are still attractive," says Graybill, who recommends sticking with senior debt. "If you're going to invest in bonds, you want to be the senior-most creditor."

But the real action could be happening in the world of preferred shares. Until recently, preferreds have been volatile, as managers tried to figure out which banks would suspend dividends. (Citigroup did in fact suspend all preferred dividends.) Now investors are playing a different game: betting which preferred shares could be the target of exchange offers from banks that hope to convert the shares into common stock.

Citigroup, for one, is basically eliminating its preferred shares, converting them all to common. But other banks are likely to convert only some of their preferreds into common, and now investors are trying to figure out which banks will take the plunge—and which classes of preferreds they will swap.

Alluring but risky: BofA's Series E

Bank of America (BAC) has the biggest capital hole to fill. Despite its recent success in selling its stake in China Construction bank for $7.3 billion and its plans to sell 1.25 billion common shares to raise another $11 billion, BofA will need still more cash to fill its need for $33.9 billion. "They have a lot of wood to chop," says Phil Jacoby, senior portfolio manager of the Principal Preferred Securities Fund (PPSAX). Other possible candidates include Fifth Third Bancorp (FITB), PNC Financial (PNC), Regions Financial (RF), and SunTrust (STI), according to a report from Barclays Capital (BCS). KeyCorp (KEY) could be looking to convert trust preferred securities, a variation on traditional preferred shares that currently trade at less than 60¢ on the dollar, according to Barclays.

Investors should then determine the class of preferred shares that will be exchanged first—usually by finding the largest issue with the highest dividend rate. In Bank of America's case, that's an issue known as Bank of America Series E. This security has a floating rate that can't go lower than 4% and currently trades at around 40¢ on the dollar. If Bank of America does decide to convert this issue, it could make the offer at nearly twice that, Jacoby says. The risk is that Bank of America won't convert the shares, leaving investors with a security they may not want long term. This is not an investment for the faint of heart.

Other managers see opportunities in hybrids—supersubordinated debt that gets treated as equity on a bank's books. Hybrids begin by paying a fixed rate before converting to a floating one. For example, a PNC hybrid maturing in 2049 pays a fixed rate of 12%. In 2012, it will convert to a floating rate 8.61 percentage points above the London Interbank Offered Rate, a benchmark rate used on corporate loans.

For hybrids, buy strong banks

But here's the catch: At the time of the conversion, banks have the right to buy these bonds back from investors at face value. That's a good thing. Since the floating rates are higher than a bank could get in the market now (and one assumes they will still be higher when the bonds convert) the banks will most likely choose to buy them back, says John Boland, a principal at Maple Capital Management. The upshot is that investors receive a high yield for three to four years and should then get their principal back to invest someplace else.

Yet much could go wrong. For starters, the bank could decide not to call the bonds, leaving investors holding a fixed-income product that doesn't mature until sometime in the 2040s. They're also near the bottom of the capital structure, only a step above common and preferred stock. For that reason, Edward Maran, a portfolio manager at the Thornburg Value Fund (TVAFX), recommends sticking with such stronger banks as JPMorgan Chase (JPM), Goldman Sachs, and US Bancorp (USB).

Or investors can just keep it simple. If they truly believe in the future of the U.S. financial industry, they can wait for a pullback in share prices and then buy a financial mutual fund or an exchange traded fund such as the Financial Select Sector SPDR (XLF), diversifying the holdings. Just because the stress test is finished doesn't mean the industry's troubles are over.

"There's still some baggage [in the industry]," says Kevin Mahn, Chief Investment Officer at Hennion & Walsh Asset Management. "It's very difficult to know which [bank] will suffer the most difficulty the next time around."

Levisohn is a staff editor at BusinessWeek covering finance and personal finance.

Levisohn is a staff editor at BusinessWeek covering finance and personal finance.